The Tradeoff Between Liquidity and Performance: Private Assets in Institutional Portfolios

The Tradeoff Between Liquidity and Performance: Private Assets in Institutional Portfolios

October 9, 2019 0 By Kody Olson


[ Music ]>>In recent years, institutional investors
have allocated increasing amount of capital to private assets, such as private
equity, real estate, and private credit. Private assets can offer potential greater
returns and diversification benefits; however, they can be very illiquid
and costly to liquidate. We developed an asset allocation framework
that helps investors determine the optimal mix of private and public assets, as well as the mix
within both the private and public portfolios. This is how we define an
optimal asset allocation, it is the one that maximizes expected portfolio
performance, while making all cash liabilities with a desired level of confidence. Investors may wonder if they are
sacrificing too much portfolio performance for the sake of liquidity. They can use the framework to answer
questions, such as how does an allocation to private illiquid assets affect my confidence
of making all future cash obligations? They can also use the framework
to explore how their allocation to private assets affects the composition
of their liquid public portfolio. [ Music ] An important feature of this
asset allocation framework is that it explicitly incorporates some of the
private asset characteristics, for example, the delay and uncertainty of capital
cost, lumpy and a high transaction costs, as well as there are high idiosyncratic risks. Through this framework, investors can conduct
extensive what-if analyses, for example, how does private asset allocation will change
if the investor assumes higher transaction costs for private assets, or better private assets
performance relative to public assets. The framework is simulation based. For each potential asset allocation, it simulates many scenarios
of portfolio performance. From these results, we can determine the
best mix of assets, public versus private, that will maximize portfolio performance
subject to the desired degree of liquidity.>>Ultimately, our framework is
flexible and highly customizable. More importantly, the framework
allows investors to measure the cost of making their portfolios more liquid. Increasing a portfolio’s
liquidity typically implies that the portfolio must become less risky and
have a lower allocation to private assets. Fundamentally, the framework allows
the investor to quantify the tradeoff between portfolio performance and liquidity, helping the investor make
better business decisions. [ Music ]